You have the following initial information on CMR Co. on which to base your calc

Question

You have the following initial information on CMR Co. on which to base your calculations and discussion for questions 1) and 2) . Current long-term and target debt-equity ratio (D:E) 1:3 Corporate tax rate (Tc)-30% Expected inflation 1.65% Equity beta (B1.6485 Debt beta (o)0.2155 Expected market premium (rM-r)-6.00% Risk-free rate (r)-3.15% 1 The CEO of CMR Co., for which you are CFO, has requested that you evaluate a potential investment in a new project. The proposed project requires an initial outlay of $6.15 billion. Once completed (1 year from initial outlay) it will provide a real net cash flow of $475 million in perpetuity following its completion. It has the same business risk as CMR Co.'s existing activities and will be funded using the firm's current target D:E ratio. a) What is the nominal weighted-average cost of capital (WACC) for this project? (3 marks) b) As CFo, do you recommend investment in this project? Justify your answer (numerically). (2 marks) 2) Assume now a firm that is an existing customer of CMR Co. is considering a buyout of CMR Co. to allow them to integrate production activities. The potential acquiring firm's management has approached an investment bank for advice. The bank believes that the firm can gear CMR Co. to a higher level, given that its existing management has been highly conservative in its use of debt. It also notes that the customer's firm has the same cost of debt as that of CMR Co. Thus, it has suggested use of a target debt-equity ratio of 2:3 when undertaking valuation calculations. a) What would the required rate of return for BFS Co.'s equity become if the proposed gearing structure were adopted following acquisition by the customer? (2 marks) b) Would the above project described in1) be viable for the new owner of BFS Co.? Justify your aswer (numerically) (3 marks

Explanation / Answer

Question 1:

a. Debt to equity is of the ratio 1:3

So weight of debt (Wd) = 1/4 = 0.25

Weight of equity (We)= 1-0.25 = 0.75

After tax cost of debt =( rf + (rm-rf)* debt beta)*(1-tax rate)

After tax cost of debt( Rd) = (3.15 + 6.0*0.2155)*(1-0.3) = 3.1101%

Cost of equity(Re) = Rf + equity beta* expected market premium = 3.15 + 1.6485*6 13.041%

WACC = Rd * Wd + We * Re = 3.1101*0.25 +13.041*0.75 = 10.56% (Rounded to two decimals)

WACC of this project =  10.56% (Rounded to two decimals)

b. Here we would calculate the net present value(NPV) of the cash flows:

Here we have the cash flows grwing at inflation rate for perpetuity

NPV = Cash inflow in year 1/ (WACC - inflation) - initial cash outflow

NPV = 475,000,000/(0.1056-0.0165) - 6,150,000,000

NPV = -818,911,335.60 (negative)

Since the NPV is negatvie, I do not recommnend investing in this project

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